Since the beginning of electricity grids, demand has fluctuated and supply has been made to follow along. But for decades, economists and some grid engineers have dreamed of having demand play a more active role in balancing the system. With increasing use of intermittent renewable energy resources, now is the time to make that demand-response dream come true. But we can only get there if we get past a common misconception in the world of electricity policy:

Paying customers to reduce their demand – such as through the common Peak-Time Rebates (PTR) — is not the same as time-varying electricity prices. PTR is a very inefficient alternative to charging time-varying rates that reflect the true time-varying cost of electricity.

No, I mean that literally, where to start? What’s the baseline level from which you start paying for reduction? In nearly all programs, baselines are based on the customer’s consumption in the recent past, usually on other high-demand days.

But such “endogenous” baseline setting distorts incentives for conservation. When my baseline for peak-time reduction is based on consumption during other high-demand days it undermines my incentive to conserve on those other days. Frank Wolak demonstrated that this effect is significant in his study of Anaheim. It can even lead to intentionally increasing consumption during baseline-setting times, as was uncovered at the Baltimore Orioles baseball stadium, which was turning on stadium lights during electricity shortages in order to be paid to then shut them off.

Camden Yards: Home of the Baltimore Orioles and a scofflaw energy manager

The distorted incentives also undermine long-run investments in energy efficiency. Sure, a more efficient air conditioner will cut my usage at critical times when the utility is paying rebates, but it will also cut my usage at baseline-setting times, which will lower my rebates, thus reducing my incentive to upgrade the A/C. In contrast, time-varying pricing — where prices are reduced in most hours, but higher during high-demand times – results in bigger (and appropriate) rewards for buying the efficient A/C.

Once the baseline is set, another problem pops up: The incentive to conserve changes drastically around the baseline quantity. Rebate programs pay for reductions below the baseline, but don’t charge extra for going above the baseline. Take a typical hot summer day when a conservation rebate day is announced. On top of the customer facing a price of, say $0.20/kWh, she now will get a rebate of $0.60/kWh for the difference between her baseline and her actual consumption, but only if she cuts consumption below the baseline quantity. That means that below the baseline quantity the incentive to save is $0.80/kWh – the electricity price she saves by consuming one less kWh plus the rebate she gets for doing so. But above the baseline, the incentive to save is still just $0.20.

The economic cost of consuming a kWh changes drastically at baseline quantity

The way PTR baselines are set, on a typical critical day nearly half of all customers will be far enough above their baseline quantity that they won’t have any shot at getting the rebate and therefore won’t have any extra incentive to cut consumption. In addition, many of the customers who do end up below baseline and receive a rebate will be there by accident, for instance because they just happen to have been away from home that day. In demand reduction studies, these people who receive subsidies for doing something they would have done anyway are called “free riders.” Wolak and other studies have shown that most of the demand reducers who get paid the rebate are actually free riders.

The drastic change in the effective price at the baseline quantity has another effect that goes against fairness: it rewards random variation in consumption. Here’s a fictional example:

Catherine’s consumption during the baseline setting period has established a baseline quantity of 50 kWh during each of two conservation rebate days. She is a reliable sort, who dutifully reduces her consumption to 45 kWh on each conservation rebate day. The rebate is $0.60 per kWh “saved,” so for cutting her consumption to 45 kWh on each day, saving a total of 10kWh on the two days, she receives a total rebate of $6.00.

Max is the flighty, unpredictable type. He has also established a baseline quantity of 50 kWh, but on one of the two rebate days he’s away from home anyway and his consumption drops to 20 kWh. On the other day, he stays home and cranks up the A/C, raising his consumption to 70 kWh. His average consumption on the two days is 45 kWh per day, just like Catherine, but his total rebate is $18.00, all received for his 20kWh day.

Max’s rebate is three times as large as Catherine’s even though his average reduction on the rebate days is the same. That’s because when Max decreases his consumption he gets the $0.60 rebate for every kWh below the baseline, but when he goes above baseline he doesn’t have to pay the extra $0.60. The sudden change in the effective price at the baseline quantity rewards people with unpredictable demand relative to people who have reliable consumption patterns. If during each hour the price were the same for all kWh that Catherine and Max consume, Max would be getting the same bill savings as Catherine. That’s what would happen if Max and Catherine were on time-varying pricing instead of PTR.

If PTRs are so bad, why are they so popular? Because they hide the cost. Rather than a higher price on the hottest days of the year — reflecting the truly higher cost of providing electricity on those days – PTR pays out for conservation (real or imaginary) on those hot days and raises the price a bit on all other days to cover the cost. Thus, customers who consume a higher share of their electricity on non-peak days (e.g., those who use less, or no, air conditioning) subsidize heavy peak-time users who manage to be slightly less heavy users on a specific peak day.

Some defenders of PTR say it is the way to transition to time-varying electricity pricing. I’m very skeptical. Once a customer gets used to being paid for reducing consumption on peak days, it is very difficult to change to a system that just charges higher prices on those days. There may be a utility that has managed to move from fully-implemented PTR to time-varying pricing, but I’m not aware of any example.

To integrate intermittent renewable energy sources, we really need to start taking demand-side participation seriously. PTR is an inefficient route to that end that will end up paying for a lot of faux “demand reduction.” Time-varying pricing is the direct route to the goal. Sacramento Municipal Utility has recently had a very successful rollout of critical-peak pricing, one form of time-varying pricing, which the real Catherine has blogged about. My own research suggests that time-varying pricing would reduce bills for the majority of residential and industrial customers, and that it would raise bills by more than 20% for only a few percent of customers. Those are the customers who consume the most at peak times and impose the most cost on the system. Prices that reflect the cost of electricity would be a more effective way to integrate renewables and a fairer way to allocate the costs.

If you want an even geekier discussion of the problems with PTR, I recorded a screencast video on the subject for my MBA course on Energy & Environmental Markets.

Severin Borenstein is the E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business, where he teaches courses in Business Economics and Energy & Environmental Markets. He is also Co-Director of the Energy Institute at Haas and Director of the University of California Energy Institute. He has been a research associate of the National Bureau of ...

Thanks Nathan. I think the answer is to offer time-varying pricing on an optional basis, preferably an opt-out basis. People who want can still have a flat rate, but they will be pooled with others who want a flat rate, who might have a more costly load profile. I outline this approach in a paper at http://ei.haas.berkeley.edu/pdf/working_papers/WP229.pdf. By the way, SMUD has run an opt-out pilot for critical-peak pricing that has been very successful (over 90% choose to stay with it). The report on that is linked towards the end of this blog.

Ok, so PTRs (Peak Time Rebates) are flawed, but straight time-of-use metering has problems too (namely the potential to expose consumers to onerous price spikes, just when they want electricity the most).

A lot of the billing discussion comes down to philisophy. One could argue that we should only pay for the grid capital costs during the summer peak, and pay only for fuel-cost the rest of the time (i.e. zero in an all renewable grid). Or that long-time electricity users should not have to pay for grid expansions that are only needed to accomodate new users. Or each utility should use a system that mirrors its wholesale market (e.g. sub-hourly bid/clearing or the utility owns and depreciates all generations assets year-round).

I understand there is a desire to provide an incentive for conservation, but consumer preference must play a role too. People generally prefer to own seldom-used assets like boats and airplanes (and air conditioners), rather than paying for them by the hour (the cost of fuel, which is a small part of the total cost, is adequate to discourage wasteful use). They like phone plans with unlimited calling (note that unlimited nights and weekends is less popular, even though it is a cheaper service to provide).

We need a balance, one that does not expose electricity users to the full incremental cost of that last kW of system capacity.